By Chris Allbritton and Zeeshan Haider
ISLAMABAD (Reuters) - A U.S. decision to suspend $800 million in military aid to Pakistan is more likely to drive the wedge between the troubled allies deeper than compel the military to fight harder against Taliban and al-Qaeda linked militants on its territory,
White House Chief of Staff William Daley confirmed on Sunday a New York Times report that the Obama administration had held off a third of $2 billion in security aid in a show of displeasure over Pakistan's cutback of U.S. military trainers, limits on visa for U.S. personnel and other bilateral irritants.
The United States provides about $300 million a year to reimburse Pakistan for deploying more than 100,000 troops along the Afghan border to combat militant groups, the Times said. Other funding covers training and military hardware.
It would be damaging to the relationship if Washington held back on these funds, said Pakistan's former ambassador to the United States, retired major-general Mehmood Durrani said, reflecting a widespread view in Pakistan that it was fighting America's war, and Washington must pay for it.
"This is something that they have to pay, and if they don't then it's breach of agreement and breach of trust."
The U.S.-Pakistan relationship has been on a downward spiral since last year, but the decline accelerated after the killing of two Pakistanis by a CIA contractor in Lahore in January and the U.S. raid to kill Osama bin Laden, which Pakistan complains it was not told about and says was a breach of its sovereignty.
Pakistan has demanded the number of U.S. military personnel in Pakistan be slashed, and the U.S. has complied. Pakistan also wants to cut the number of U.S. intelligence officials.
Secretary of State Hillary Clinton said last month that Washington is not prepared to continue the same levels of military aid to Pakistan unless it sees some changes in the relationship.
Washington wants the Pakistan military to cut ties with the militant groups it has nurtured in the past, and launch ground operations in its North Waziristan region, now a hub of militants from around the world.
Pakistan says it is doing all it can to fight militants, including a deadly militancy at home which has left thousands dead.
Ayesha Siddiqa, an expert on the Pakistan military, downplayed the military impact of the cuts, saying it was not "substantial enough to immediately change policy."
"Is it going to majorly undermine operations? I don't think so."
The U.S. cutback may, however, influence the Pakistanis to do the exact opposite of what the Americans are pushing them to do, Siddiqa said.
The decrease in training, spare parts and specialized equipment might push the Pakistani military to negotiate with groups rather than fight them, she said.
"If the partnership frays," she said. "Pakistan is no longer seen as fighting America's war. You can negotiate with militant groups then."
But, she added, that would only be to seek breathing room while the army recalibrates the balancing act it has maintained for a decade: Stage enough military operations to keep anti-Pakistan militants off-balance (and U.S. money flowing in) but avoid going all out against militant groups targeting allied troops in Afghanistan.
"There will be no major change of strategy."
But while the military could weather the storm, Pakistan's economy might be hit if Washington holds back on what is called the Coalition Support Fund.
The CSF is not aid, but reimbursements for money already spent on military operations, and it goes into the general treasury. So holding back these payments won't hurt the military, but would strain the country's finances further at a time when it is battling a deep downturn.
This is part of a high-stakes stand-off between the United States and Pakistan, Siddiqa said. Washington has given up on winning Pakistani hearts and minds and is now counting on Pakistan's precarious financial situation to bring it onside.
"America understands that Pakistan needs money," she said. "Pakistan is insolvent. It cannot disengage (from the United States), so eventually it will turn around."
"Military aid is just an indicator of what American can do," she added. "If they pull back economic aid as well, everything else would dry up, including the multilaterals."
Negotiations with the International Monetary Fund, which is propping up Pakistan's economy with a $11 billion loan program, could be affected.
"The short-term effect would be more political than economic because it sends out a negative signal that Pakistan and U.S. relations are not going well at this moment," said Asif Qureshi, director at Invisor Securities Ltd.
U.S. support was pivotal to securing an agreement in November 2008 for an $11 billion IMF loan to financially-strapped Pakistan. In August 2010, the IMF stopped releasing funds because of Pakistan's patchy implementation of fiscal reforms the government promised to carry out.
If ties became truly frigid, Pakistan could seek deeper ties with China, its "all weather friend."
"There are other sources," a military official said about the loss of military aid. "It may have an effect, but we are not dependent on a single source."
China is the single largest arms supplier to Pakistan, although most military analysts consider the United States' systems more technologically advanced.
(Additional reporting by Sahar Ahmed; Editing by Sanjeev Miglani)